You invest to meet your financial goals; earning high returns helps you reach there faster. But, you need to remember that your goal is the ‘dog’, and high returns the ‘tail’. And as the saying goes, you must not let the tail wag the dog. Far too often people forget this, and chase higher returns without paying heed to risks. Investing is all about future, and the future is always uncertain. This means you are always exposed to risk. You cannot eliminate risk but you can and must manage it.
How do you manage risk in investing?
Discipline and Diversification are two effective tools that help you do this. While luckily both are free, it does not mean investors use it well. We have seen a large number of portfolios, and it’s obvious that most of us, and by that we mean almost all, could do better on both these fronts.
Discipline prevents you from letting your emotions drive your investment decisions
But, discipline to do what? Discipline to follow a framework of decision-making; what to buy, at what price to buy etc. Our entire site is built on a framework of fundamental investing, it has a strong process. It does not mean that it will work wonders all the time, but following the process consistently is essential to meet your financial goals through investing, and also earning high returns.
Diversification answers: ‘How much of each Stock should you own?’
It is the answer to the third essential question you need to ask before investing; ‘How much of each stock should you own?’ Our answer is managing a diversified portfolio of not more than 20 stocks. Diversification ensures you don’t put all the eggs in one basket. So, how do you do this? But first, why 20 stocks?
How many stocks ensure sufficient diversification?
Statisticians have studied volatility of a portfolio with varying number of stocks from 2 to 500 versus the market. They concluded that volatility reduces to a large extent, when a portfolio has 16 stocks and having more than 32 stocks doesn’t materially reduce the volatility any further. So ,we believe investor must hold somewhere in the range 20 stocks to get maximum possible benefit of diversification.
Should stocks be bought equally in portfolio?
Even though we eliminate the stocks that are red i.e. not investment-worthy, not all companies that make the shortlist are equally robust. Then, why hold all business equally? Some stocks deserve higher allocation than others especially the ones with a strong and consistent performance capability, the ones with a strong sustainable moat.
Some companies’ earnings are likely to be lumpy due to cyclical nature of the business. It’s prudent to commit a lower amount to such stocks. At MoneyWorks4me, we recommend shortlisted stocks to be bought in three portfolio weightage categories viz 7%-5%-3%.
MoneyWorks4me’s Stock Allocation Strategy
We recommend 7% of portfolio weightage to superior quality and sustainable profitable growth companies. We invest 5% in most above average companies with robust cash flows and consistent ROEs, while good businesses but cyclicals, asset based business and leveraged companies fall in 3% bucket.
Using this allocation strategy, volatility of your portfolio is likely to be lower than the market, as your portfolio is skewed towards stable businesses, and volatile companies are smaller portion of the portfolio.
As you can infer with this allocation strategy a portfolio can have maximum of 33 stocks and minimum of 14 stocks. In all likelihood, 20-25 stock is what your portfolio will have when you follow this process. As you can see, when you only have space for about 20 stocks only, you should not be tempted to include mediocre and risky companies in your portfolio.
How to reduce risk further through better portfolio management?
Every good portfolio manager follows some thumb rules to avoid risks that arise due to the composition of the portfolio. There are three such risks and good thumb-rules that you should follow:
1. Sector Exposure Risk:
Invest less than 25% in any one sector; don’t exceed it. This ensures you are not over-exposed to a particular sector. In case that sector faces certain challenges you can handle the turbulence better. Of-course, you need to have selected strong companies within the sector.
2. Stock Concentration Risk:
Our 7-5-3% portfolio weightage method ensures that you are not over exposed to any particular company-stock. Even if, the stock runs up faster than other, avoid exceeding twice the original allocation i.e. 14-10-6% by booking some profits
3. Market Cap Risk:
Small cap companies with a good business model grow faster, which leads to a large rise in their stock prices and results in very good returns. Hence, they may find a place in your portfolio. However, their performance could be strongly affected by economic downturn, commodity prices, lack of resources, etc. There is the additional risk of not knowing enough about the company, since small caps are not studied as closely as large caps. This exposes you to the risk of poor governance and fraud. If you have a moderate risk profile, you should invest not more than 20% in small caps. This will enable you to participate in the potential for growth from small caps, while limiting the market capitalization risk to your overall portfolio. Simultaneously, invest 60% in large caps with low volatility and steady returns.
In investing, you are always exposed to risk whether it materializes or not. If you invest for a reasonable time, you will encounter risk, and how you react to that makes a big difference to meeting your goals
Read our blog on Risks at the Portfolio-level and Risks at the Stock-level to know more.
If you have an existing Stocks portfolio, you can identify risks in your portfolio real-time, and get recommended actions to reduce them , with our Portfolio Manager, for free! Just register and upload your portfolio.
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